Macroeconomics Part 3 Jamshed uz Zaman Ref: Dornbusch and Fischer Macroeconomics 6 th Edition

Classical Theory According to the Classical theory Real wages (W/P) are determined by demand for labor and supply of labor, When unemployment increases, real wage rate would decline, A fall in W/P will reduce the labor supply under the assumption of a normally upward rising supply of labor,

Classical Theory (contd.)

A fall in W/P will increase the demand for labor since the demand curve of labor slopes downward, Therefore, employment will tend to rise. Eventually full employment will be restored.

Classical Theory (contd.) According to classical theory S = S(i)Savings function I = I(i)Investment function S = IEquilibrium condition Both Saving and Investment are function of interest rate

Classical Product Market

Keynesian Theory Unlike classical theory, Keynes believed that wages could be inflexible downwards, because of the labor union’s resistance, Savings is determined by income (Y) rather than interest rate (i), At macro-level expenditure (E) determines income (Y). Total expenditure is, Y = C + I

Keynesian Theory (contd.) Consumption depends on income, C = a + bY Where b = ΔC/ ΔY = c’ a = Autonomous consumption. Again ΔY = ΔC + ΔI Dividing by ΔY 1 = ΔC/ ΔY + ΔI/ ΔY

Keynesian Theory (contd.) Or, 1 - ΔC/ ΔY = ΔI/ ΔY Or, ΔY/ ΔI = 1/(1 - ΔC/ ΔY ) Or, 1/(1-c’) = 1/s’ Or, ΔY = 1/(1-c’). ΔI Expenditure will increase to the extent of change in investment multiplied by multiplier.

Keynesian Theory (contd.)

Definition The IS curve shows combination of interest rates and levels of output such that planned spending equals income.

Investment Savings – IS Curve

Shift in IS Curve

DEMAND FOR MONEY AND REAL BALANCES Money market has, like all other markets, both a demand side and a supply side. Demand side: Nobody demands money. Demand for money is a temporary phenomenon.

Three kinds of Demand There are three reasons for demanding money Transaction demand Precautionary demand Speculative demand

Precaution and Transaction Precautionary demand depends on income level. Richer a person holds higher cash for precaution. Transaction demand depends on income. It is a fraction of income. Transaction demand = k(y) and k’ > 0

Speculative Demand A person can put his liquid assets into either money or bonds. An increase in interest rate, or the rate of return on bonds, will temp people to put more of his assets into bonds and less into money. This inclination to hold more or less money depending on the interest rate on bonds is called speculative demand for money.

Speculative Demand (contd.) Speculative demand = l(i), where l is liquidity preference, l’<0. When interest rate rises speculative demand goes down.

Total Demand Avoiding precautionary demand, we can add up transaction and speculative demand in to demand for real money (M/P =m ). Demand for money can be shown as, M/P = l(i) + k(y) The demand for money function can be written as M/P = m(r, y) With δm/δi 0

Demand for Money

Supply Side of Money On the supply side, we assume that money supply is fixed. M = Money supply is defined as Narrow money = currency + demand deposits Broad money = currency + demand deposits + time deposits M3 etc.

Equilibrium of Demand for and Supply of Money

Derivation and shift: LM Curve